Read This Before Buying Telstra Corporation Limited (ASX:TLS) For Its Dividend

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Today we’ll take a closer look at Telstra Corporation Limited (ASX:TLS) from a dividend investor’s perspective. Owning a strong business and reinvesting the dividends is widely seen as an attractive way of growing your wealth. On the other hand, investors have been known to buy a stock because of its yield, and then lose money if the company’s dividend doesn’t live up to expectations.

In this case, Telstra likely looks attractive to investors, given its 3.4% dividend yield and a payment history of over ten years. It would not be a surprise to discover that many investors buy it for the dividends. Some simple research can reduce the risk of buying Telstra for its dividend – read on to learn more.

Explore this interactive chart for our latest analysis on Telstra!

ASX:TLS Historical Dividend Yield, July 1st 2019
ASX:TLS Historical Dividend Yield, July 1st 2019

Payout ratios

Dividends are usually paid out of company earnings. If a company is paying more than it earns, then the dividend might become unsustainable – hardly an ideal situation. Comparing dividend payments to a company’s net profit after tax is a simple way of reality-checking whether a dividend is sustainable. In the last year, Telstra paid out 48% of its profit as dividends. This is a middling range that strikes a nice balance between paying dividends to shareholders, and retaining enough earnings to invest in future growth. One of the risks is that management reinvests the retained capital poorly instead of paying a higher dividend.

In addition to comparing dividends against profits, we should inspect whether the company generated enough cash to pay its dividend. The company paid out 78% of its free cash flow as dividends last year, which is adequate, but reduces the wriggle room in the event of a downturn. It’s positive to see that Telstra’s dividend is covered by both profits and cash flow, since this is generally a sign that the dividend is sustainable, and a lower payout ratio usually suggests a greater margin of safety before the dividend gets cut.

Is Telstra’s Balance Sheet Risky?

As Telstra has a meaningful amount of debt, we need to check its balance sheet to see if the company might have debt risks. A rough way to check this is with these two simple ratios: a) net debt divided by EBITDA (earnings before interest, tax, depreciation and amortisation), and b) net interest cover. Net debt to EBITDA measures total debt load relative to company earnings (lower = less debt), while net interest cover measures the ability to pay interest on the debt (higher = greater ability to pay interest costs). With net debt of 2.96 times its EBITDA, Telstra has a noticeable amount of debt, although if business stays steady, this may not be overly concerning.

We calculated its interest cover by measuring its earnings before interest and tax (EBIT), and dividing this by the company’s net interest expense. Interest cover of 4.67 times its interest expense is starting to become a concern for Telstra, and be aware that lenders may place additional restrictions on the company as well.

Dividend Volatility

One of the major risks of relying on dividend income, is the potential for a company to struggle financially and cut its dividend. Not only is your income cut, but the value of your investment declines as well – nasty. For the purpose of this article, we only scrutinise the last decade of Telstra’s dividend payments. Its dividend payments have fallen by 20% or more on at least one occasion over the past ten years. During the past ten-year period, the first annual payment was AU$0.28 in 2009, compared to AU$0.13 last year. The dividend has shrunk at around 7.4% a year during that period. Telstra’s dividend hasn’t shrunk linearly at 7.4% per annum, but the CAGR is a useful estimate of the historical rate of change.

A shrinking dividend over a ten-year period is not ideal, and we’d be concerned about investing in a dividend stock that lacks a solid record of growing dividends per share.

Dividend Growth Potential

Given that dividend payments have been shrinking like a glacier in a warming world, we need to check if there are some bright spots on the horizon. In the last five years, Telstra’s earnings per share have shrunk at approximately 2.1% per annum. Declining earnings per share over a number of years is not a great sign for the dividend investor. Without some improvement, this does not bode well for the long term value of a company’s dividend.

Conclusion

When we look at a dividend stock, we need to form a judgement on whether the dividend will grow, if the company is able to maintain it in a wide range of economic circumstances, and if the dividend payout is sustainable. Telstra’s dividend payout ratios are within normal bounds, although we note its cash flow is not as strong as the income statement would suggest. Second, earnings per share have been in decline, and its dividend has been cut at least once in the past. Ultimately, Telstra comes up short on our dividend analysis. It’s not that we think it is a bad company – just that there are likely more appealing dividend prospects out there on this analysis.

Given that earnings are not growing, the dividend does not look nearly so attractive. See if the 11 analysts are forecasting a turnaround in our free collection of analyst estimates here.

If you are a dividend investor, you might also want to look at our curated list of dividend stocks yielding above 3%.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.